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Friday, May 16, 2014

Equities and Bonds: Signs that Bears May Have More Firepower

In essentially every update I've written this month, I've noted that the S&P 500 (SPX) appeared likely to rally to new all-time highs, but that rally would be a head-fake breakout doomed to whipsaw. It's probably fair to say that was a decent call, and my only concern at this point is that it seemed so incredibly obvious and it almost happened "too easy." (That always makes me a little nervous.) It's certainly too soon to say with certainty that we've seen an intermediate top, but with everything going according to plan, there's presently no reason to doubt that thesis either.

The simple solution is that bulls will need to sustain trade north of 1903 to cast doubt on the bear case; so until that happens, or until there are signs of a meaningful bottom, the bear case will remain favored. Today we'll also take another look at some of the supporting players to the bear case for equities.

The first is the US 30-year Treasury Bond (USB). On February 20, I wrote that I felt the long bond was on its way to 138-140 -- the funny thing is, at roughly the same time, nearly 100% of economists surveyed felt that bonds were heading lower. So that's something to consider, for those folks who view technical analysis as some kind of pointless voodoo.

The long bond is still implying a shift toward risk off, and thus hints at the potential of continued trouble for equities.

Next up is a chart I haven't updated since mid-April -- this chart tracks the ratio of the iShares High Yeild Corporate Bond Fund (HYG) to the iShares Barclays 20+ Year Treasury Bond (TLT). I use this as a measure of risk-on/risk-off: When the ratio heads lower, it means risk-off, which is bad for equities. In March, I mentioned that HYG:TLT had broken through the uptrend line that began in 2012, and felt that was a warning sign. Now this ratio is breaking down from a pretty ominous-looking head and shoulders, and this could suggest more trouble on the horizon for risk assets.

Finally, the SPX chart, and I'm going to break down the time frames separately to avoid confusion.

Bigger picture, RSI suggests new lows are on the horizon for SPX one way or another -- so whether we rally near-term or not, I'd be surprised if 1862 isn't broken in the coming sessions.

Near-term, there are two ways to view the recent decline:

1. The conventional way to view the big drop as the belly of wave iii-down of 1-down. That would mean the bounce that began yesterday is merely a fourth wave consolidation that should be fairly short-lived. In that count, the market is still forming wave A or 1 down, with wave v-down of 1-down still to come.

2. The way I'm tempted to view the decline, though, is as all of wave 1-down. Instead of viewing the big drop as wave iii-down, I suspect it may have been an extended fifth wave. Calling extended fifths is difficult, though, because the technical indicators literally don't work -- so it's all about "feel." These are the types of calls I run with as a trader, but shy away from as an analyst, so do with this what you will. If this was an extended fifth, then expect a retrace rally toward 1879-82 (the chart says 80-82), followed by a retest of the 1863-70 zone, followed by another rally leg up toward 1888.

If SPX sustains trade beneath 1862, then we're probably dealing with option 1. If SPX sustains trade north of 1873, then option 2 has a decent shot.

Not shown on the above charts: SPX recently tested the 50-day moving average for the third time in three weeks, and may thus be exhausting buyers in that zone. If it tests the 50-dma a fourth time, then it's likely to break -- and that could spark a decent sell-off, since a fair number of traders use the 50-dma as a stop zone. That hypothetical fits my expectation that SPX is completing wave 1 down, with the wave 2-up rally on deck -- to be followed by wave 3-down. That third wave would coincide with a break of the 50-dma, which could provide selling fuel to power the decline. The third wave is usually the longest and strongest of a move, so I like the overall setup.

In conclusion, while it's too early to confirm an intermediate top, everything has gone according to plan, so the preferred view will remain bearish on the bigger picture until such time as the market says we should consider other options. Presently, the first thing bulls would need to accomplish is to sustain trade north of 1903 -- but since RSI confirmed the 1862 low, it appears unlikely that will happen immediately. It instead looks likely that new lows are on the horizon one way or another. And, as discussed, new lows will break the 50-dma, which could spark an extended sell-off. Trade safe.

Follow me on Twitter while I try to figure out exactly how to make practical use of Twitter: @PretzelLogic

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